It is difficult to identify precisely which ingredients are provoking the greatest change in the South Korea-Japan airline market. First, in mid/late 2012 the market was transformed as new airlines entered and others added capacity; these were mainly LCCs with unprecedented low fares. Then late 2012 saw Japanese outbound tourist numbers fall sharply due to political tensions between South Korea and Japan over largely uninhabited but disputed islands.

In 2013 the Japanese outbound market remains soft as the yen weakens. While the international political situation will eventually cool down, the Korean response has been to target individual tourists rather than tour groups, a change that was long overdue in any event.

But the difference now is that those individuals have LCCs to provide for their needs. These carriers are here to stay, and they will grow – for the usual reasons, but also due to the weakening yen. While the economic and political factors favour the Korean side, it is the Japanese side that has a larger share of the market.

Japan-Korea yields are declining rapidly – but are still plush, with room for downside

Of the carriers linking Japan and Korea, only Asiana discloses yields by region, but the carrier’s performance is considered a bellwether for the larger market. Asiana is also the second-largest carrier in the market, accounting for about 27% of capacity, so it offers a strong indication of the market's direction.

Japan to South Korea (seats per week, one way): 19-Sep-2011 to 3-Nov-2013

Asiana recorded a modest 0.3% year-on-year yield decline in 2Q2012, followed by a larger 4.7% decline in 3Q2012, 14.2% decline in 4Q2012 and 15.8% decline in 1Q2013.

While the rate of decline is alarming, yields are still plush – some of the highest in the industry’s key markets. Over the last year the lowest quarterly yield in monetary terms was 1Q2013 when yields decreased to USD17.4 cents per kilometre – a level that would make most airlines envious.

But there will be consequences. Korean carriers do not have as high a cost base as Japanese airlines, for instance, but still average costs higher than Cathay Pacific and Singapore Airlines.

Japanese yields prop up the rest of the Korean carriers’ networks, driving up the average yield. In 1Q2013, Japan was still the highest-yielding region on a per km basis; next was China and the smaller CIS market.

Japan in 1Q2013 accounted for 16% of international passenger revenue at Asiana compared to 15.7% for China and 2% for CIS (the largest is Southeast Asia at 25.1%, followed by North America at 19.2%). International passenger revenue accounted for 60.2% of Asiana's overall revenue in 1Q2013 (the next largest earner is cargo at 25.6%).

Asiana yield by region (USD cents): 1Q2013

Source: Asiana

Japan’s disproportionately larger contribution to revenue is evidenced from revenue on Asiana's Japanese routes in 1Q2013 contributing 16%, despite only accounting for 9.8% of ASKs and 9.4% of RPKs.

Yields need to be higher on services from Korea to Japan than North America or even Southeast Asia given the shorter route distance, unlike Korea-North America/Europe or even Southeast Asia. Those longer routes allow greater scale of costs. The short-haul nature of the Japan-Korea market does not afford great scale, thus increasing costs and necessitating higher yields to make a profit.

Korean Air reported a drop in revenue from Japanese routes in 1Q2013 and Japan's contribution to overall international passenger revenue is down 3ppt.

Some growth has been curtailed, but overall capacity is up; Korea-Japan market change is complex

Despite this decline, capacity is not shrinking but rather growing. Large shifts have occurred in other North Asian markets, including China-Japan and China-Philippines, each driven almost entirely by territorial disputes. Sharp capacity reductions followed.

The Korea-Japan market is more intricate, however. The fervour of the Korea-Japan territorial dispute is more muted than occurred between China and Japan in late 2012. The fundamental conditions for travel between Korea and Japan are sound, unlike China-Japan where strong nationalist sentiment in China saw Chinese unwilling to travel to Japan, while Japanese did not feel welcome in China.

The challenge facing the Korea-Japan market is a shift in marketing and distribution: away from package groups, which largely buy from the lowest seller and, directionally, more towards Korean rather than Japanese travellers. Cost reductions from legacy carriers would enable them to reach more passengers without sacrificing profitability, but cost reductions are a long road. LCCs may very well capture this segment before legacy carriers are able to implement notable cost reductions.

Some capacity reduction is in order at the very least to boost load factors (74% from Asiana in 1Q2013). Capacity reductions would also be wise while carriers re-adjust their revenue strategy, but reductions like that seen between China and Japan are not necessary.

The message from carriers is one of cautious capacity increases. Asiana will postpone some growth outside trunk routes while in some markets look to grow through scale, such as up-gauging routes (Incheon-Sendai from A321 to 767) rather than introducing additional frequencies.

The first punch: LCCs enter with historically low prices

2012 saw three carriers enter the Japan-Korea market with low fares. First was Peach Aviation, the LCC partially owned by All Nippon Airways. Peach launched domestic flights in Mar-2012 and quickly moved in to the international market in May-2012 with a daily service from its Osaka Kansai hub to Seoul Incheon, bringing the route to three daily in Jun-2012, capacity it still maintains. Lead-in/headline sale fares were offered for JPY5,280 (USD53) one way and some sale fares have even gone down to JPY3,000 (USD30) for the 862km one-way sector.

The lowest economy fare available in the market prior to Peach’s entry was typically between USD400-500 return, according to Google/ITA. In the Kansai-Incheon market Peach has half the capacity of Asiana and less than half that of Korean Air but the incumbents have lowered fares in response. Since Peach’s entry the lowest available economy fare according to Google/ITA has hovered closer to USD400 and in 2013 decreased to USD350.

A sample Kansai-Incheon return fare with taxes for a trip one month in advance was USD352 on Korean Air while Peach's "Happy Plus" fare that includes checked luggage and seat assignment was USD218 (a yield of USD10.3 cents/km). Foregoing all frills, the trip price drops to USD168 (a yield of USD7.4 cents/km).

Peach’s fare was so low that day shopping trips to Seoul became popular tourist activities from Japan and Peach even offered special fares for day trips. The mere thought a mere year prior of the middle class taking a day's shopping trip to Seoul would have been farfetched and extravagant.

A similar story unfolded at Tokyo Narita, the base of AirAsia Japan, which launched daily Narita-Incheon services in Oct-2012 after its Aug-2012 domestic launch. The lowest available fare had been around USD450 according to Google/ITA, but quickly declined to levels closer to USD400 despite AirAsia Japan having a smaller share of the market (5%) than Peach does between Kansai and Incheon (about 20%).

Fares from Narita are being further pressured from the entry later in 2013 of Korean LCC Jeju Air and fares are dropping to below USD300. A sample AirAsia Japan fare from Narita to Incheon return with taxes booked a month in advance during a regular (non-sale) period was JPY17,070 (USD173).

The smaller Tokyo Haneda-Seoul Incheon market, which still sees capacity only from Asiana and Korean Air, has not been impacted by LCC activity as the airport maintains strong business traffic due to Haneda's location near downtown Tokyo. While fares have fluctuated, this has been the result of Asiana largely adjusting capacity each week based on demand.

The third entrant bringing lower fares was Starflyer’s launch in Jul-2012 of double daily flights from its Kitakyushu hub to Busan. While the route was the first international service for Kitakyushu, and so there were no existing direct fares to be lowered, it added to the atmosphere – pushing towards expectation – of lower Korea-Japan fares.

Competition will only increase. Jetstar Japan has yet to enter international markets but flagged Korea will be a large target for it. AirAsia Japan has not yet gained Peach’s scale. All of the carriers will later link other points in Japan with Korea in addition to ramping up trunk routes. In the grand scheme of what these LCCs will do for the market, their existing capacity is a drop in the bucket - but has already wrought significant change, generating new consumer expectations and offering real alternatives.

The second impact: Japanese visitor numbers decline due to political tensions

Territorial disputes in Asia may conjure images from 2012’s Japan-China flare-up of Chinese citizens protesting Japan and even damaging Japanese cars in China, but there has been a smaller dispute between Korea and Japan over the Dokdo/Takeshima islands, largely uninhabited, insignificant but claimed by both. Tension flared in Aug-2012 when Korea's president visited the islands, an action followed in subsequent months by bringing media to the islands and promoting the islands in mainland Korea.

Japan tourism figures for its outbound market showed Oct-2012 and Nov-2012 traffic declined to levels not seen since 2008. Oct-2012 had a year-on-year decline of 20.7% while Nov-2012 declined 24.8%. Dec-2012 traffic had not been since 2007 (year-on-year decline of 24%), Jan-2013 not seen since 2011 (year-on-year decline of 15.5%) and Feb-2013 not seen since 2008 (year-on-year decline of 26.2%). (Note: figures from Dec-2012 are still Japan’s estimates.)

Japanese departing for Korea: Jan-2000 to Feb-2013

Source: CAPA – Centre for Aviation and JTO

Asiana saw slightly deeper passenger falls. Traffic earlier in the year showed strong gains (mainly impacted by weakened 2011 traffic due to the Mar-2011 Japanese earthquake) and then flat summer growth. Korean Air has not disclosed statistics.

Asiana monthly passengers from Japan: 2012

Source: Asiana

Within the market, however, passenger segmentation is diversifying. Japanese passengers on group bookings fell even more sharply (about 35%) than the average (20-25%). This was partially compensated by a slight (7%) increase in individual passengers, but in Nov-2012 these accounted for only about 28% of Asiana’s Japan-Korea traffic. Individual passengers were typically 20-30% of Asiana’s Japanese traffic during 2012.

Korean visitors to Japan from Oct-2012 to Dec-2012 hit two year highs, although this in line with the rebound the market was seeing throughout the year. Korean visitors to Japan are still down from all time highs around 2008 and 2011.

Korea arrivals in Japan: Jan-2000 to Feb-2013

Source: CAPA – Centre for Aviation and JTO

Comparisons have since become blurred from the depreciation of the Japanese yen. Overall the Japanese market was down 28.7% in 4Q2012 for Asiana and 12% down in 1Q2013, indicating the political situation is bottoming out but that is now being replaced as a feature by the depreciation of the yen.

The Japan-Korea market is being impacted by currency exchange. The Japanese yen has depreciated significantly, part of the country's "Abenomics" programme (named after Prime Minister Shinzo Abe) that essentially aims to weaken the yen so the country's exports – now lagging – are more affordable in overseas markets. That first part has been realised, with Japanese companies posting significant increases in profits.

The second component, those companies increasing the wage of their Japanese employees, largely remains to be seen, although Tokyo is reminding companies of the need to look after their employees.

JPY:USD exchange rate: May-2008 to May-2013

Source: XE

At the same time, the Korean won has been appreciating slightly.

KRW:USD exchange rate: May-2008 to May-2013

Source: XE

The combined effect is that Koreans visiting Japan since early 2013 have enjoyed significantly higher purchasing power - while Japanese purchasing power is declining significantly.

KRW:JPY exchange rate: May-2008 to May-2013

Source: XE

The Japan-Korea market is weighted towards Japan outbound travellers, which since 2009 have on average accounted for 62.5% of the directional market. (This excludes other nationalities either travelling locally or on sixth freedom itineraries.)

Share of Japanese and Korean visitor arrivals in the Japan-Korea market: 2000-2012

Source: CAPA – Centre for Aviation and JTO

Japan’s hold on the market should continue to decrease as the yen weakens, and preliminary figures show Koreans accounting for more than half of the market in early 2013. The weakening yen makes foreign travel more expensive for Japanese passengers but foreigners (including Koreans) have greater buying power in Japan.

Asiana in 4Q2012 saw a 35% increase in tourists to Japan because of the weakened yen. The challenge is sourcing new segments in the comparatively smaller Korean market to make up for decreased demand from Japan.

Koreans in 2007 travelled in greater numbers than the Japanese between Japan and Korea. 2013 and subsequent years may see this pattern replicated.

Japanese and Korean visitor arrivals in the Japan-Korea market: 2000-2012

Source: CAPA – Centre for Aviation and JTO

Outlook: Japanese and Korean legacies, inertia-laden, are being tested; short haul spokes are increasingly challenged

This is not a time to be sitting back in the Korea-Japan market, but so far that appears to be the response from the legacy incumbents - perhaps hoping the competition will go away. They would not be the first to make that mistake; European airlines did so in the late 1990s and never recovered their positions. Existing services are not being consolidated to make up for the substantial declines in yield, nor is there a great deal of improvement in revenue management strategies to ensure higher load factors. The carriers may be profitable, but they could be more profitable.

And this only addresses their full-service operation. Asiana and Korean Air have LCC subsidiaries, the respective Air Busan and Jin Air, launched less out of innovation and more out of a need to respond and suppress the burgeoning independent LCC market in Korea that emerged mid/late last decade.

They have effectively been kept at bay. Air Busan has a lonely daily service to Narita, two to Kansai (but both from Busan, not Seoul), while Jin Air serves neither, despite an open skies agreement with Japan.

Other carriers will continue to be happy to exploit this inertia. Peach, barely a year old, is now the third-largest LCC between Korea and Japan after Jeju Air and Air Busan. Jeju Air, the independent Korean LCC, will enter Seoul Incheon-Tokyo Narita in Jul-2013 with two daily flights.

ANA and JAL, each with foreign LCC specialist partners, have accepted that LCCs will cannibalise part of their networks, but Asiana and Korean Air seem to be hoping they can buck the global trend. This may have been possible when the competition was confined to local Korean carriers, but as the market becomes more international and external companies intrude, the chemistry changes.

As LCCs compete in a more price-sensitive Japan-Korea market, the Korean carriers’ healthy connecting traffic will also come under further competitive pressure - another feature which became increasingly troubling to European airlines as the LCC market expanded.

ANA and JAL are rapidly opening new long-haul routes, reaching into secondary cities, hoping to make their proposition more attractive to a market familiar with Korean’s extensive long-haul network. As China Eastern in particular expands, it too will target the sixth freedom market from Japan that Korean Air has relied on to partially fill Korea-Japan seats.

This is a dynamic market with pushes and pulls relating to the economic, political and competitive environment.

Japan's airlines are being confronted by an unusual confluence of challenges - a quick drop in the yen, increasing external costs like fuel and lease charges, and simultaneously suppressing outbound discretionary travel; unpredictable political pressures, affecting bilateral travel patterns; the growing incursions by LCCs, both part subsidiaries and independent, international and domestic; and, unfortunately timed too, the recent uncertanties and delays in operation of the 787. All of these make long term strategy the victim of a need to react in the short term.

The region's full service airlines do not have a reputation for policy agility, but it will be useful characteristic to nurture over the next year. Based on experiences in every other world market, there are a number of areas where the incumbents will have no ability to protect market share. But the extent of the negative impact they suffer will depend greatly on how fast they are able to adapt to these new challenges. Looking the other way will not work this time.

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